Can an uninformed trader profit from buying and then selling an asset? Despite Friedman's (1953) conclusion that arbitrage would make such a strategy self-defeating, some financial economists have concluded that profitable "trade-based" manipulation is feasible. Allen and Gale (1992) and Aggarwal and Wu (2004) demonstrate the possibility of a pooling equilibrium in which the typical trader cannot distinguish informed investors and would-be manipulators, allowing the latter to influence prices strategically. Other models rely on investor irrationality or other departures from market efficiency. In Jarrow's (1992) model, prices have momentum, enabling a manipulator to establish a price trend and then profit by trading against it. Mei, Wu and Zhou (2004) demonstrate that a trader can exploit investor biases by buying to drive up prices, then selling at a profit.
The harder question is whether profitable trade-based manipulation is common in actual asset markets. Camerer (1998) describes an experimental attempt to manipulate prices (odds) in a horse race that failed to generate expected profits. The Securities and Exchange Commission (SEC) brings enforcement actions against alleged manipulators, primarily in small and illiquid stocks. During the internet boom in particular, the SEC took action against "pump and dump" schemes in which a trader made large purchases (sometimes coupled with the release of false information) and then sold after a price increase. Aggarwal and Wu (2004) study all stocks involved in SEC anti-manipulation enforcement actions from 1990 to 2001 and find that prices, trading volumes, and volatility rise during the alleged manipulation and prices fall afterwards, suggesting that profitable manipulation could have occurred.
Outside the limited context of penny stocks and other illiquid markets, the evidence of profitable trade-based manipulation is anecdotal. The most famous alleged manipulations are the stock pools of the 1920s, through which groups of investors actively traded in a specified stock. The stock pools are the main cause of the current anti-manipulation laws in the United States and often motivate academic discussions of market manipulation. The apparent success of the stock pools continues to influence regulatory policies, such as Securities and Exchange Commission (SEC) rules regarding stabilization during public offerings.
Mahoney (1999), however, studies the average price behavior of stocks traded by pools in 1928 and 1929 and argues that there is little evidence that pools were engaged in manipulation. While these stocks earned positive (but modest) abnormal returns on average around the time of pool formation, they did not subsequently earn abnormally negative average returns, as would be expected if the pool's trades artificially inflated stock prices. The qualitative evidence regarding pools is also ambiguous. Pool participants routinely testified that they were informed traders or were trading to add liquidity. The Senate's hearings were polemical and generated little hard evidence of manipulation.
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Market Manipulation: A Comprehensive Study of Stock Pools
